By Karamjeet Paul (Published by American Banker/BankThink September 25, 2014)

The financial services industry is often caught in a debate about whether it faces too much regulation or not nearly enough. This is a valid topic of discussion. But it distracts from another, even more critical matter: regulations in the aftermath of the most recent financial crisis have failed to effectively address the root problem that caused so many bank failures.

For the first time in history, regulators are requiring financial institutions to have a specific amount of liquid assets on hand to withstand a 30-day run by creditors and depositors, should a sudden crisis strike again. This is a right step to keep the system from freezing as happened in 2008.

However, will focusing on liquidity prevent what can devastate institutions in crises as experienced by Bear Stearns, Lehman and Wachovia? No, it will not, because institutional liquidity problems in crises are caused by a more fundamental factor.

The big news this week is that large banks will be required to have a higher level of capital in the form of a surcharge amount of capital.

The Wall Street Journal reported on September 9, 2014 (“Fed to Hit Bog Banks With Stiffer Surcharge”) that the new requirements are “aimed at reducing the risk …” and the required increase in capital would be “calibrated to the relative riskiness of the bank as measured by a series of factors.”

Large banks, or may be most banks, may very well need more capital. But this need for capital has not been tied directly to what causes the need for capital in the first place. Some of these “series of factors” aren’t necessarily a measure of what creates the capital requirement.

Capital is needed to cushion unexpected losses arising from extreme-tail risk, which carries the exposure that can result in devastations in extreme crisis. Therefore, the amount of the capital need should be driven by an explicit measure of extreme-tail risk. Unless an objective and transparent measure of extreme risk is used, proposals often lead to the use of factors that are not necessarily connected to extreme risk.

An example, as reported by the WSJ: “One new wrinkle in the Fed’s plan is to tie the size of the surcharge to a bank’s reliance on short-term financing …” The use of short-term financing creates liquidity risk, which matters in a crisis only if extreme-tail risk is perceived to be excessive. It doesn’t create extreme-tail risk. So a surcharge for this factor will have no bearing to the need for capital to deal with extreme risk in crises.

Unless, extreme-tail risk is addressed explicitly, a higher amount of capital will not accomplish what the Fed is trying to do. According to William Coen, Secretary General of the Basel Committee on Banking Supervision, “The answer isn’t simply to say you need another X basis points in capital. Maybe the better response is to require the bank to present a detailed plan on how it’s going to better manage these risks and to make sure the bank sticks to that plan.”

The debate about capital adequacy in the banking industry is not new. Those who have been in the industry long enough know that it has been around for at least 30-40 years. To date, the industry has resisted any change to the status quo, with a result that in the post-2008 world, regulators will define the needed change using subjective measures and opinions backed by the Dodd-Frank Act provisions. Such an approach will actually make banks more vulnerable than stronger in crises.

Lets face it. The status quo, as rationalized currently, is unacceptable. So either the capital requirement has to change or a new rationalization is needed. Rather than fighting or struggling to cope with the regulatory proposal, the industry must proactively come up with an objective approach to capital adequacy rationale that gets to the root of the problem.

I believe the use of an objective and simple measure like “Probable Maximum Loss,” along with an explicit focus on extreme-tail risk, can bring objectivity to this discussion and help make banks and the financial system stronger. As part of the suggestion by Mr. Coen, regulators should insist, and institutions on their own should develop effective plans for extreme-tail risk.

About 30 years ago, many considered banking a mature industry. Revenue growth was sputtering, as the existing pie was being shared with new players such as GE Capital and Fidelity, and higher-credit-quality companies were turning to commercial paper. The era of bank “disintermediation” was moving into high gear.

Then came an unparalleled and fairly-sudden combination of 4 dynamics: (i) quants introduced the ability to model almost every element of financial risk, (ii) an unprecedented leap in the ability to manipulate huge amounts of data allowed quant models to create financial products manageable from desktops, (iii) securitization transformed almost any financial product into a tradable security, and (iv) the transformation wrought by the preceding 3 dynamics opened the way for a vast new world of “innovation,” in which the components of financial products could be stripped and recombined into a highly leveraged, ever more abstract world of structured securities and derivatives. Take away any one of these and the last 25 years would be very different.

This combination, akin to firing solid-rocket boosters from a craft losing altitude, enabled the industry to soar into unimagined new orbits. Capital markets, once competitors, became sources of new revenues. Instead of intermediating liquidity, financial institutions began intermediating risk between sources and users of liquidity, amassing on their books huge amounts of risk that would drive their revenue models.

With so much riding on risk, institutions invested gazillions into risk management. By 2008, risk management was the most sophisticated discipline the industry had ever had. So, why were banks so badly blind-sided?

Those calling for higher capital requirements for banks have the right objective of making financial institutions and the system stronger (everybody agrees with that objective). However, their proposals to increase capital don’t receive support from everyone because their approach is not a proven one.

In a New York Times article on August 10, 2014, “When She Talk, Banks Shudder,” Prof. Anat Admati of Stanford University was quoted as offering an analogy of what’s wrong with banks today: “My comparison is to speed limits. Basically what we have here is the market has decided nobody else should be driving faster than 70 miles an hour and these are the biggest trucks with the most explosive cargo and they are driving at almost 100 miles an hour.”